Econ 101: Principles of Microeconomics
Chapter 15 - Oligopoly
Fall 2010
Herriges (ISU)
Ch. 15 Oligopoly
Fall 2010
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Fall 2010
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Outline
1
Understanding Oligopolies
2
Game Theory
The Prisoner’s Dilemma
Overcoming the Prisoner’s Dilemma
3
Antitrust Policy
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Ch. 15 Oligopoly
The Oligopoly
Monopolies are quiet rare, in part due to regulatory efforts to
discourage them.
However, there are many markets that are dominated by a relatively
few firms, known as oligopolies.
The term oligopoly comes from two Greek words: oligoi meaning
“few” and poleein meaning “to sell”.
Examples of oligopolies include:
1
2
3
4
5
6
7
Airliner Manufacturing: Boeing and Airbus
Food Processing: Kraft Food, PepsiCo and Nestle
US Beer Production: Anheuser-Busch and MillerCoors
US Film Industry: Disney, Paramount, Warners, Columbia, 20th
Century Fox and Universal
US Music Industry: Universal Music Group, Sony Music Entertainment,
Warner Music Group, and EMI Group
Academic Publishing: Elsevier, Kluwer
US Airline Industry: Delta/NWA, United, American
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Ch. 15 Oligopoly
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The Problem With Oligopolies
The problem with oligopolies is much that same as with
monopolies–the firms realized they have some market power because
relatively few firms provide the good or service.
Oligopolies still compete– it’s just that the competition is not always
as rigorous.
The situation in which both competition occurs and firms exercise
market power is known as imperfect competition
The market power of the oligopoly will typically result in higher prices
and lower production levels in the market than would be efficient
However, the competition among firms, and particularly their
incentives to cheat on each other, will dampen this effect relative to a
monopoly.
Oligopolies are a very difficult type of market structure to study,
relative to either perfect competition or a monopoly.
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Ch. 15 Oligopoly
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Determining Whether an Oligopoly Exists
An oligopoly is defined, not by the size of the firms, but by their
relative market shares.
Essentially, if relatively few firms control most of the market sales,
then an oligopoly exists.
One commonly used measure of market concentration is the
Herfindahl-Hirschman Index (HHI), which is defined as:
HHI =
N
X
Si2
(1)
i=1
where
Si denotes the percent of market controlled by the i th firm
N denotes the number of firms in the market.
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Ch. 15 Oligopoly
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More on HHI’s
The HHI ranges from zero to 10000 (i.e., 1002 in the case of a
monopoly)
The US Department of Justice uses the following cutoffs:
-
HHI < 100 indicates a highly competitive market.
100 < HHI < 1, 000 indicates an unconcentrated market.
1, 000 < HHI < 1, 800 indicates a moderately concentrated market.
HHI > 1, 800 indicates a highly concentrated market.
HHI examples:
PC Operating Systems: HHI=9,182 (Microsoft, Linux)
Wide-Body Aircraft: HHI=5,098 (Boeing, Airbus)
Diamond Mining: HHI=2,338 (De Beers, Alrosa, Rio Tinto)
Movie Distributors: HHI=1,096 (roughly equivalent to 10 first each
owning 10% of the market)
Retail Grocers: HHI=321
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An Alternative View
A less formal way of looking at market concentration is to examine
the market shares held by the top few firms in an industry.
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Ch. 15 Oligopoly
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Understanding Oligopolies
Understanding Oligopolies
The difficulty in studying oligopolies in general is that there are so
many possible ways in which the firms might interact with each other.
1
They might collude; i.e., cooperate with each other so as to maximize
their joint profits, dividing up the profit among the firms.
Such collusion might take the form of overt collusion (such as forming
a cartel)
Alternatively it might be indirect, implicit collusion.
2
They might also act non-cooperatively, acting in their own self-interest,
but taking into account the actions of other firms.
In many ways, the actions of the firms become similar to playing
games, such as Monopoly or Risk.
Efforts to model such strategic interactions has led to a whole branch
of economics and math known as game theory
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Ch. 15 Oligopoly
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Understanding Oligopolies
The Duopoly
In order to understand some of the possible behaviors in the case of
oligopolies, consider the simplest case - the duopoly (i.e., two firms).
Think, for example, of the airliner industry, which is dominated by
two firms (Boeing and Airbus).
Suppose that the demand for airliners in any given month is given by
Price
($mill.)
4.00
3.50
3.00
2.50
2.00
1.50
1.00
0.50
0
Quantity
Demanded
0
1
2
3
4
5
6
7
8
Total Revenue
TR = P × Q
0
3.50
6.00
7.50
8.00
7.50
6.00
3.50
0
Marginal Revenue
MR = ∆TR/∆Q
3.50
2.50
1.50
0.50
-0.50
-1.50
-2.50
-3.50
If MC=1.75, how much would a monopoly produce? Q=2
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Ch. 15 Oligopoly
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Understanding Oligopolies
The Collusion Outcome
One alternative in the case of a duopoly would be for the two firms to
form a cartel
A cartel is an agreement among several producers to obey output
restrictions in order to increase their joint profit.
Essentially, the cartel acts like a monopolist and simply divides the
market among members of the cartel.
The most famous example of this is the Organization of Petroleum
Exporting Countries (OPEC)
OPEC was formed in 1960’s in response to quotas instituted by
President Eisenhower and enforced on Venezuela and Persian Gulf
Countries.
The success of OPEC has varied over time with conditions in the
market and geo-political relations among its members and customers.
Cartels are typically illegal within countries, but in the case of OPEC,
the cartel is made up of countries.
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Ch. 15 Oligopoly
Fall 2010
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Understanding Oligopolies
The Airline Industry Example
In our airline duopoly, the cartel outcome would be to produce Q=2
with P=3.00, dividing the market between the two firms (i.e., Qi = 1
for each firm).
Assume for simplicity that there are no fixed costs and that MC are
constant (i.e., MC=ATC) at 1.75.
The profit for each firm would be:
Profit = TR − TC = (P − ATC ) × Qi = (3 − 1.75) × 1 = $1.25 mill.
The problem for our cartel is that each firm has an incentive to cheat.
- Suppose Boeing stuck to the agreement, making only 1 airplane
(QB = 1), but Airbus decided to cheat, making 2 airplanes (QA = 2).
- With total output at Q = QA + QB = 3, price drops to 2.50.
- Airbus’s profit rises to
(P − ATC ) × QA = (2.50 − 1.75) × 2 = $1.50 mill.
- Boeing’s profit, however, falls to
(P − ATC ) × QB = (2.50 − 1.75) × 1 = $0.75 mill.
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Ch. 15 Oligopoly
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Understanding Oligopolies
The Incentive to Cheat
Where does the incentive to cheat come from?
When Airbus cheats, two things change:
1
2
The positive quantity effect: Airbus is able to sell more units (and
Boeing looses out on this gain).
The negative price effect: Both Airbus and Boeing face a lower price
for what they do sell.
- Note that for this negative effect, the companies share this burden.
Boeing is clearly hurt by the cheating
Airbus, however, gains, since the quantity effect more than offsets the
price effect.
Of course, Boeing also has the same incentive to cheat.
If they both cheat and produce 2 units each, then Q = 4, P = 2, and
both firm’s profits drop to
(P − ATC ) × Qi = (2.00 − 1.75) × 2 = $0.50 mill.
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Ch. 15 Oligopoly
Fall 2010
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Game Theory
Analyzing the Behavior of Oligopolists
Oligopoly presents the greatest challenge to economists
The essence of oligopoly is strategic interdependence
Each firm anticipates actions of its rivals when making decisions
In order to understand and predict behavior in oligopoly markets
- Economists have had to modify the tools used to analyze other market
structures and to develop entirely new tools as well
One approach–game theory–has yielded rich insights into oligopoly
behavior
Game theory deals with any situation in which the reward of any one
player (called the payoff) depends on not only his or her own actions
but also on those of other players in the game.
In the case of a two-player game, the interaction is depicted using the
payoff matrix.
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Ch. 15 Oligopoly
Game Theory
Fall 2010
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The Prisoner’s Dilemma
The Prisoner’s Dilemma
Perhaps the most famous “game” is the so-called Prison’s Dilemma.
The underlying story here involves two accomplices in a crime who
have been caught.
The police have enough evidence to convict them of a lesser crime,
putting them in prison for 5 years each.
However, they also suspect that the two are guilty of a more serious
crime, but lack the evidence to convict them
The goal of the police is to get one or both to confess to the more
serious crime and implicate their partner in the process.
Separating the two so that they can talk, they promise each that
- If they confess (and their partner does not) they will get a more lenient
sentence of 2 years.
- If they refuse to confess (and their partner does), they will have the
book thrown at them with a 20-year sentence.
- If both confess, both get a 15-year sentence.
What is the payoff matrix for this game and what should each player
do?
Herriges (ISU)
Ch. 15 Oligopoly
Fall 2010
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Game Theory
The Prisoner’s Dilemma
The Payoff Matrix
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Ch. 15 Oligopoly
Game Theory
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Fall 2010
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The Prisoner’s Dilemma
What Should Louise Do?
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Ch. 15 Oligopoly
Game Theory
The Prisoner’s Dilemma
What Should Thelma Do?
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Ch. 15 Oligopoly
Game Theory
Fall 2010
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The Prisoner’s Dilemma
The Result in the Prisoner’s Dilemma
For each individual, their dominant strategy (i.e., their best action
regardless of what the other individual chooses to do) is to confess.
Note that this is despite the fact that both individuals would be
better off by choosing not to confess.
The result, is that both individual’s confess.
The result is what is known in game theory as a Nash Equilibrium;
i.e., an equilibrium in which each player takes the action that is best
for him or her given the actions taken by the other player.
This is named after the famous mathematician and Nobel prize
Laureate John Nash.
Because the individuals do not take into account the impact of their
actions on the other players, this is known as a noncooperative
equilibrium.
Herriges (ISU)
Ch. 15 Oligopoly
Fall 2010
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Game Theory
The Prisoner’s Dilemma
Applying the Prisoner’s Dilemma
Consider applying this problem to a duopoly of two gas stations
located in a small town.
Suppose the two gas station owners are named Sam and Gus.
To simplify the analysis, suppose that there are only two price options
for the firms: a high price and a low price.
If both firms charge a low price, their profit per firm is $25,000.
If both firms charge a high price, they both make more money, with
profit per firm increasing to $50,000.
Their fear, however, with the high price option is that the other firm
will cheat and change the low price, in which case the high price
station has a negative profit (-$10,000), while the low price station
makes $75,000.
The two owners also know that they cannot explicitly collude
This is simply a Prisoner’s Dilemma Game
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Ch. 15 Oligopoly
Game Theory
Fall 2010
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Fall 2010
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The Prisoner’s Dilemma
Gus and Sam’s Dilemma
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Ch. 15 Oligopoly
Game Theory
Overcoming the Prisoner’s Dilemma
Overcoming the Prisoner’s Dilemma
The Prisoner’s Dilemma is very simple example of a noncooperative
game
One key feature of the game is that it assumes that the players
interact only the one time
This is known in game theory as a one-shot game
In real world applications, the players may interact frequently in the
marketplace
This results in what are known as repeated games
In repeated games, strategic behavior can emerge, where players take
into account that their actions can influence the behavior of other
players.
The game is no longer noncooperative, but is now formally known as
a cooperative game.
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Ch. 15 Oligopoly
Game Theory
Fall 2010
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Overcoming the Prisoner’s Dilemma
Tit-for-Tat
One strategy in a repeated game is to:
Begin by behaving cooperatively
If the other player cheats, then you engage in cheating the next period.
This is known as the tit for tat strategy.
Sometimes, simply cheating after the other player has cheated is not
enough to enforce cooperation.
Alternatively, one can engage in a punishment stage of the game,
where you go beyond simply cheating and engage is extreme behavior
The punishment phase can even be harmful to the punisher, but is
meant to signal the cost of not cooperating.
The idea is to signal to the other player that there are significant costs
to cheating.
Examples of punishment phases show up in the real world, such as
Price wars in the airline industry
Large output increases by Saudi Arabia to induce cartel cooperation.
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Ch. 15 Oligopoly
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Game Theory
Overcoming the Prisoner’s Dilemma
Tacit Collusion
Tit for Tat games are an examples of tacit collusion; i.e., when the
firms attempt to control overall output (and hence price) indirectly
without a formal agreement.
Another form of tacit collusion is price leadership
One firm–the price leader–sets its price and other sellers copy that price
With price leadership, there is no formal agreement
Rather the decisions come about because firms realize–without formal
discussion–that system benefits all of them
Decisions include
- Choice of leader
- Criteria it uses to set its price
- Willingness of other firms to follow
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Ch. 15 Oligopoly
Game Theory
Fall 2010
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Overcoming the Prisoner’s Dilemma
The Limits to Collusion
Oligopoly power–even with collusion–has its limits
- Even colluding firms are constrained by market demand curve
- Collusion–even when it is tacit–may be illegal
- Collusion is limited by powerful incentives to cheat on any agreement
No firm wants to completely destroy a collusive agreement by
cheating, since this would mean a return to the non-cooperative
equilibrium wherein each firm earns lower profit
However, some firms may be willing to risk destroying agreement if
benefits are great enough
Cheating is most likely to occur–and collusion will be least
successful–if
1
2
3
4
There is difficulty observing other firms prices
Market demand is unstable
There are a large number of sellers
The players have different underlying objectives
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Antitrust Policy
Antitrust Policy
Prior to 1890, cartels were perfectly legal in the U.S.
In 1881, Standard Oil Company came up with a specific mechanism
for collusion: the trust.
Under this system, firms would place their shares in the hands of a
board of trustees, who would control the joint interests of the
companies involved.
In essence, this made the U.S. oil industry a monopoly (controlled by
the trust).
The public backlash led to the Sherman Antitrust Act of 1890,
making trusts (and other such forms of collusion) illegal.
In 1911, Standard Oil was broken up into a series of smaller
companies that would compete with each other.
In the past 20 years or so, the EU has also moved towards similar
antitrust efforts.
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